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ANOMALIES
Excessive Volatility
Robert J. Shiller (1981) The American Economic Review
Purpose: What accounts for movements in stock prices? there may be a human element adding to volatility
Short-term momentum
Positive short-term (6-12 months) autocorrelation in stock returns (underreaction) news is incorporated slowly into prices
Momentum Strategies: (To exploit short lags)
Create zero-cost arbitrage portfolios by buying most winners and selling most losers of the past 3-12 months, hold them for the next 3-12 months. Jegadeesh and Titman (1993) and Rauwenhorst (1998): report around 1% monthly average excess returns to this strategy.
Long-term reversal
Negative long-term (3-5 years) autocorrelation in stock returns
Contrarian Strategies:
(To exploit long lags) Buy most losers and sell most winners of the past 3-5 years, hold the portfolio for the next 3-5 years. DeBondt and Thaler (1985) report significantly positive returns to this strategy Yesterday's top performers become tomorrow's underperformers, and vice versa.
Short-lag positive and long-lag negative autocorrelation in Rt series are a violation of weak form of efficiency.
The Profitability of Technical Analysis (Trends, Trend Reversals): It may be possible to make money by following trends.
IPO Stocks Underperformance Ritter (1991): IPO stocks yield below normal returns in the 36 months following the IPO. Investors become too optimistic about IPO firms, inflating the initial IPO return (buy at a high price, stocks later underperform)
Facebook IPO
Overreaction due to Representativeness Bias: Tendency of people to underweight statistical properties of population/see patterns in random sequences/reemphasize the most recent and salient
Representativeness Bias
Investor might think that high earnings growth of a company is trending (when it is not) and overvalues the company Stock prices overreact to consistent patterns of good/bad news, creating excessive volatility (continuing trends, then reversals) This explains negative long-term autocorrelation in returns and profitability of contrarian strategy
Overconfidence: An investor tends to be overconfident about the information he has generated but NOT about public signals. Biased self-attribution: When confirming public information is received investors confidence rises. When disconfirming public information is received investors confidence falls only modestly, if at all.
Q: HOW DO THESE BIASES AFFECT MARKET BEHAVIOR? Tend to produce: - Short-run momentum - Long-run reversals
E.g. Bubbles
3. DEBATE
Efficient markets approach: Random trades SHOULD cancel out. Noise Trader approach: Random trades DO NOT cancel out. Movements in investor sentiment are an important determinant of prices
Long-term return anomalies NO EVIDENCE AGAINST EFFICIENT MARKET THEORY anomalies are chance results, underreactions are equally likely as overreactions, so they cancel each other out unpredictability of behavioral facts methodology problem temporarity of behavioral facts
Thaler (1999) The End of Behavior Finance After all, to do otherwise would be irrational
Evidence that should worry the efficient market advocates Volume Volatility Predictability Fama 1970/1991 Dividents (MM - 1958)
Why do most large companies pay cash dividends? And why do stock prices rise when dividends are initiated or increased?
Behavioral finance" will be correctly viewed as a redundant phrase After all, to do otherwise [not include the human factor in trading ] would be irrational